Manufacturing quality collateral | FT Alphaville

Manufacturing quality collateral

Regulators are demanding that banks set aside larger amounts of high-quality liquid assets to help them withstand periods of market stress.

The securities generally deemed acceptable are AAA-government bonds.

The problem is, despite large stimulus-motivated issuance by AAA governments, there’s still not enough of the quality stuff to go around. Stress in collateral markets is rising as quality collateral becomes impossible to find. The quality grab is not only forcing down yields in safe haven bonds, it’s seeing the rates charged for borrowing cash against the bonds fall to all-time lows, as investors scramble to acquire securities in order to satisfy liquidity requirements. The crunch has further been heightened by the general trend towards collateralised lending and funding, usually on an overcollateralisation basis.

As Godfried De Vidts as Chairman of ICMA’s European Repo Council told FT Alphaville this week:

“You can’t just ask for USTs and market bunds, or else the market will grind to a halt”

So what’s a monetary institution to do?

As FT Alphaville has noted before, the quality collateral shortage is particularly striking in Australia, where sovereign debt levels are much smaller than the rest of AAA land.

Naturally, it’s a problem which has caught the attention of the Reserve Bank of Australia.

Having thought long and hard about how to overcome it, the RBA announced on November 15 that it felt the best course of action would be the creation of a brand new new facility.

As the details noted:

As foreshadowed last December, the Reserve Bank will provide a committed liquidity facility (CLF) as part of Australia’s implementation of the Basel III liquidity reforms. Details of APRA’s proposed implementation of the Basel III liquidity standard are being released concurrently with this announcement. For further details see Implementing Basel III liquidity reforms in Australia. The facility, which is required because of the limited amount of government debt in Australia, is designed to ensure that participating authorised deposit-taking institutions (ADIs) have enough access to liquidity to respond to an acute stress scenario, as specified under the liquidity standard.

It’s an interesting solution.

Guy Debelle, Assistant Governor of the RBA, offers some more insight via a speech he made this week in Sydney.

As he explains the RBA only really had three options: balance sheet expansion, dedicated debt issuance solely for the purpose of creating AAA-bonds, or the creation of the CLF:

In addition to government debt, the Basel standard also includes balances at the central bank in its definition of high-quality liquid assets (level 1 assets in the Basel terminology). That is, the banks’ exchange settlement (ES) balances at the RBA are also a liquid asset. Hence, one possible solution to the shortage of level 1 assets would be for banks to significantly increase the size of their ES balances to meet their liquidity needs.

While this is possible, it would mean that the RBA’s balance sheet would increase considerably.

The RBA would have to determine what assets it would be willing to hold against the increase in its liabilities, and would be confronted by the same problem of the shortage of assets in Australia outside the banking system.

Similarly, the government could increase its debt issuance substantially with the sole purpose of providing a liquid asset for the banking system to hold. Again, it would be confronted with the problem of which assets to buy with the proceeds of its increased debt issuance. Moreover, it would be a perverse outcome for the liquidity standard to be dictating a government’s debt strategy.

However, the Basel Committee acknowledges that there are jurisdictions such as Australia where there is a clear shortage of high quality liquid assets. In such circumstances, the liquidity standard allows for a committed liquidity facility to be provided by the central bank against eligible collateral to enable banks to meet the LCR.

What is the CLF? It’s basically a pre-arranged commitment by the RBA to swap liquidity in exchange for a specific quota of assets less liquid than government bonds. It is thus a guaranteed liquidity option. If you need liquidity, you will always be able to swap your illiquid securities for liquid RBA reserves for a cost of no more than 25 basis points above the target rate.

In this way, the central bank is guaranteeing liquidity and the credit of the securities pledged, and they count as liquid reserves under Basel III.

The fee is justified by the degree to which the market has underpriced liquidity risk in recent years:

However, part of the point of the new liquidity regulations is to recognise that the market has underpriced liquidity in the past. Consequently, it is appropriate to levy a fee which is greater than implied by a long run of historical data. The net outcome is thus a weighted average of a relatively low liquidity premium in normal times and a much higher liquidity premium in stressed times.

In determining the fee, it must be remembered that ADIs will not only have the option of meeting their LCR requirements through the Reserve Bank’s liquidity facility, they will always have the option of meeting their LCR requirements through holding RBA obligations. This is because, as mentioned earlier, ES balances are also recognised as liquid assets.

Meanwhile, because Australia suffers from the phenomenon of too many “inside” securities in one market, the judgment is that to limit exposure to competitor banks, banks will be able to submit their own securitised paper for the facility too:

As mentioned earlier, a large share of the securities on issue in Australia are “inside” the banking system. That is, they are securities issued by the banks themselves. The available pool of outside assets in Australia which includes securities issued by supranationals and corporates is small. Hence, the primary type of asset available in the market to the banking system to meet its liquidity needs is a security issued by another bank. In our judgement, and that of APRA’s, it would be undesirable for a bank to meet its liquidity needs by significantly increasing its exposure to the rest of the banking system. If a stressed situation was to arise at one bank, the increased cross-holdings could rapidly translate this to other banks. Moreover, if the stressed bank was to meet its liquidity needs by selling its holdings of securities issued by other banks into the market, this would also serve as a possible source of contagion to the rest of the banking system.

Thus to reduce the likelihood of systemic risk, a bank will be able to hold some share of its liquid assets in the form of self-securitised mortgages. There is a trade-off here between systemic risk and reduced “market” liquidity of the bank’s asset holdings, but the bank will have access to liquidity from the RBA with these assets. In terms of the range of assets eligible for the CLF, the RBA reserves the right to broaden that range at any time, but will give 12 months’ notice of any decision to narrow the range. The latter condition will give banks adequate time to adjust their liquids holdings in response to any change.

All in all, another example of collateral transformation — this time on a mightily more official level. But the question is will it work?

And more importantly, if the crisis afflicting the Eurozone is just as much about a collateral crunch and market illiquidity, to what degree could a similar facility like this work there?

Related links:
One man’s haircut is another man’s unsecured risk – FT Alphaville
On the perils of plunging repo rates – FT Alphaville
The committed liquidity facility – BIS